Commentary: Private insecurities

We just marked the 10th anniversary of the Private Securities Litigation Reform Act (PSLRA), which attempted to curb abuses in securities class-action litigation by eliminating so-called "professional plaintiffs" and instituting more-stringent pleading standards. While the PSLRA has discouraged some meritless lawsuits, the evidence suggests that our private securities-litigation system still needs additional reform.

Take a look at the numbers. Since the passage of the PSLRA, the size of securities class-action settlements and the number of companies involved in this litigation have grown substantially. Data compiled by Laura Simmons and Ellen Ryan of Cornerstone Research show that the total inflation-adjusted value of securities class-action settlements increased to $9.6 billion in 2005 from $150 million in 1997. Over the same period, the average inflation-adjusted size of settlements increased over sevenfold, to $78 million from $10.7 million. These increases are largely driven by the proliferation of "mega-settlements" in excess of $100 million, such as last year's WorldCom settlement of more than $6 billion.

Data compiled by the Stanford Law School and Cornerstone Research also show that the percentage of listed companies that were defendants in federal securities class-actions has increased rather steadily from 0.8% in 1996 to 1.5% in 1997, and to over 2% in each year between 1998 and 2005. A disproportionate amount of post-PSLRA class-action suits have been targeted at companies that are large or and have volatile stock prices. Some 60% of the companies in the Dow Jones Industrial Index have been sued in securities class-actions since 1999, including Proctor & Gamble, Johnson & Johnson, Pfizer and Intel, which have remarkable records at creating shareholder value. None of them were defendants in the period from 1995 to 1999.

Almost one-third of the companies in the Nasdaq Biotech Index and more than one-half of the firms in the Nasdaq Internet Index have been targets of federal class-action securities lawsuits since the enactment of the PSLRA. Insofar that some, if not most, of these suits are driven more by the volatility of these companies' stock prices than they are by fraud, these suits have a disruptive effect on important high-growth industries.

Almost none of these lawsuits ever go to trial. Most are settled, even if a company feels that the case is without merit, because the risks and costs of going to trial are great. For example, suppose that a class-action suit is brought against a company with alleged damages of $1 billion. If the defendant believes there is only a 10% probability that the plaintiffs will prevail, the defendant faces an expected judgment of $100 million (i.e., 10% times $1 billion). In this simple example, it would be more rational to settle the suit, even for as much as $99.9 million. Hence, even frivolous suits are settled for large amounts.

A recent study, by Prof. Anjan Thakor of Washington University and Jeffrey Nielsen and David Gulley of Navigant Consulting, followed trades by 2,394 institutional investors and class-action settlements since the enactment of the PSLRA in 1995. It reveals a fundamental problem: The compensation investors receive in settlements of federal securities class-actions does not correspond to the harm investors incur from alleged securities fraud. In the post-PSLRA system, large diversified institutional investors are often overcompensated as a result of a class-action while smaller, undiversified investors, including individual "Ma and Pa" types, are not.

•	Commentary: Private insecurities Wall Street Journal, Wednesday, Feb. 15, 2006 Byline: Kenneth M. Lehn